With many homes being “underwater” (the value of the home is lower than the mortgage amount), some homeowners have been successful in negotiating with banks to forgive a portion of their mortgage.

Does that affect their taxes? Normally, if you borrow money and the lender later forgives the debt, you may have to include the cancelled amount as income for tax purposes. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.

However, the Mortgage Debt Relief Act of 2007 allows homeowners in an underwater situation to exclude income from the discharge of debt on their principal residence. Debt either reduced through mortgage restructuring or forgiveness in connection with a foreclosure, qualifies for such tax relief.

But, you have to get involved in this now! Barring any new legislation, only debt forgiven in calendar years 2007 through 2012 qualifies under the Debt Relief Act. So if you are in the process of restructuring your mortgage with your bank, be sure to have the debt forgiven in 2012 to avoid having to list that portion as taxable income.